Two Ways to Fix the Corporate Income Tax: Internationalize it or Kill It

In an important new paper, Eric Toder of the Tax Policy Center and Alan Viard of the American Enterprise Institute say that corporate tax reforms now being debated in Congress fall far short of solving the widespread problems with the levy. Rather than merely lowering rates and tinkering with tax rules for U.S.- based multi-national corporations, as President Obama and many members of Congress have proposed, Toder and Viard argue that the corporate system needs what they call “major surgery.”

In a paper funded by the Peter G. Peterson Foundation, they propose two alternatives: Either build a tax based on a broad international agreement on how to allocate corporate income among countries, or kill the corporate income tax entirely and replace it with a direct tax on shareholders. In such a system, capital gains would be taxed as they accrue rather than when they are realized upon the sale of shares.

Toder and Viard have both been around Washington a long time and neither has any illusions about the political and technical challenges of either change. But, they argue, the policy options currently on the table “fail to resolve the fundamental contradictions in the current corporate income tax.”

The corporate tax has many well-known shortcomings. Two of the biggest: It’s inability to respond to both the explosion of international commerce and the growing share of corporate income produced with intellectual property. Because the U.S. tax on multinational corporations is based on corporate residence and income source—economic concepts that increasingly lack clear meaning in the real world---it is relatively simple for firms to manipulate the law to reduce their tax liability.

They argue that current reform proposals could improve matters on the margin, but can’t resolve these basic contradictions. Neither would the extreme options of either taxing accrued income of U.S. multinationals on a world-wide basis or exempting foreign-source income from tax.

World-wide taxation might prevent U.S. multinationals from shifting reported income to low-tax countries, but it would also place them at a competitive disadvantage if other countries don’t impose similar rules on their multinationals. A pure territorial tax that exempts all foreign-source income would make U.S. multinationals more competitive, but would encourage them to shift investments and reported income overseas.

What to do? As Viard and Toder see it, there are two options. Neither is perfect but both address the problems a single country has in imposing unilateral tax rules on global entities.

The first would encourage the United States to seek an agreement with other countries on a uniform rule for allocating corporate income among jurisdictions. For instance, countries could apportion income by formula, or agree to tax income from intangibles (such as patents) based on the location of sales. The base erosion and profit shifting (BEPS) project at the OECD, undertaken at the request of the G-20, is exploring ways countries can cooperate to reduce tax avoidance by multinationals. But the OECD has not yet addressed the basic issue of how to allocate profits of multinationals.

Alternatively, the U.S. could scrap its corporate income tax entirely for publicly-traded companies. U.S. shareholders would be taxed directly at ordinary income tax rates on their dividends and accrued gains, with a deduction for accrued losses. The tax would be based only on the residence of the shareholder, not of the corporation or on where it earned its income. Owners of closely-held businesses would pay individual income tax on their firm’s profits, just as partnerships and S corporations are taxed today.

While this design is simple, it raises many technical issues: What about shares held by tax-exempt investors such as charitable organizations or qualified retirement plans? Today, they indirectly pay corporate income tax but in this new model they’d pay no tax at all on these shares. How do you allocated profits among multiple classes of stock? What happens to existing business tax preferences, which would disappear for publicly-traded corporations but could remain in place for other businesses? [HG1] While Eric and Alan suggest some solutions, they acknowledge these are difficult issues.

Finally, there is the cost. TPC estimates that shifting to a shareholder tax would reduce federal revenues by $168 billion at 2015 income levels. How does Congress make up that lost revenue?

Viard and Toder have come up with some creative solutions to a knotty problem. At the very least, they’ve given tax wonks something to talk about. And, with luck, they may help convince lawmakers to break out of today’s non-productive corporate tax debate.

They are discussing their recommendations at a panel discussion this morning at AEI. You can link to the Webcast here.

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